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January 09, 2007


Sensible Economics?

That, according to a weekend article in The New York Times by Louis Uchitelle (brought to my attention by way of Economist's View), is what Nobel Prize winning economist George Akerlof wants to resurrect:

“I am trying to effect a return to sensible economics,” Mr. Akerlof said in an interview. “And what is sensible economics? It is very pragmatic. You think about problems in the world and you ask: can government do something about that? At the same time, you maintain your skepticism that government is often inefficient”...

More than most economists, Mr. Akerlof goes far afield to gather information that he considers to be played down or ignored in ways that leave mainstream economics divorced from real life.

In his speech, he encourages others to follow his lead, rejecting the focus on what he calls “parsimonious modeling” inspired by [Milton] Friedman. Everyday experience and observation must be returned to a prominent place in the profession, he argues.

With a hat tip to to Max Sawicky for the link, this is all a reference to the material in Dr. Akerlof's presidential address at this year's annual meeting of the American Economic Association:

The discovery of five neutralities surprised the economics profession and forced the re-thinking of macroeconomic theory... However, each of these surprise results occurs because of missing motivation. The neutralities no longer occur if decision makers have natural norms for how they should behave. This lecture suggests a new agenda for macroeconomics with inclusion of those norms.

This is a provocative and very accessible paper, and a good read (especially if you are interested in discussions about the way economists ought to go about doing economics).  But I'm not sure where it all leads, and not at all sure I'm convinced by Professor Akerlof's arguments.

The Akerlof "five neutralities" are all important ideas of that last 40 years that collectively constitute theoretical benchmarks -- though not necessarily the conventional wisdom -- for a whole lot of modern macroeconomics.  To explain my confusion/skepticism, I'll focus on one of them, Ricardian equivalence:

According to Ricardian equivalence, under somewhat special conditions, a representative consumer who receives a lump-sum intergenerational transfer (for example, in the form of a social security payment) will not spend a single dime extra. Instead she will pass on the whole extra income, dollar-for-dollar, to her heirs, who will have to pay the higher tax bills necessary to retire the increased debt incurred in funding the transfer to the previous generation.

The transfer is neutral in its effect on current consumption. 

It's a strong result and, although the evidence is not unambiguous, I think it safe to say the consensus view is that the Ricardian equivalence does not hold as a general proposition.  The Akerlof address identifies several reasons why this might be the case:

A vast literature explains why such Ricardian equivalence is unlikely to be empirically descriptive. The long list of reasons includes (1) infinite, rather than finite, horizons; (2) strategic bequests to obtain the attention of one’s heirs while alive; (3) childless families; (4) uncertainty, including bequests made because of uncertainty about the age of death; (5) differential borrowing rates between the government and the public; (6) growth of the economy in excess of the interest rate, allowing steady debt issuance; (7) lack of foresight regarding the effect of social security on future taxes; (8) foreign ownership of debt; (9) tax distortions;(10) constraints on the consumption of parents (so they do not leave bequests); (11) myopia of the parents regarding children’s future tax payments.

That's a long list, and you'd think it would be plenty explanation for why the predictions of Ricardian equivalence might fail.  But it doesn't seem to be enough for Professor Akerlof:

The preceding list gives empirical reasons for failure of Ricardian equivalence; but lengthy as it is, it still ignores its theoretical challenge. According to that challenge, under economists’ standard assumptions, with perfect certainty and with perfect foresight, Ricardian equivalence will occur. Such a result had previously been unsuspected by economists.

Perhaps this is a semantic difficulty, but this where I start to lose the thread of the argument. The theory isn't just about preferences -- that is,it isn't just about whether parents internalize the desires of their children.  The theory also includes assumptions about constraints (such as whether private and social borrowing rates differ), technologies (such as the methods of taxation available to the government), information sets (such as knowledge about the path of future taxes), equilibrium concepts (such as whether the behavior of people is strategic).  In other words, I'd argue that all of the items on the Akerlof list are theoretical elements that in turn affect the empirical predictions of the model.  Dr. Akerlof seems to have something else in mind, and I don't know what it is.

In the text, the view seems to be that we should judge a theory by guessing what we would actually observe in a world that doesn't exist, and then reject that theory if those predictions don't conform to what we expect:

In this view Ricardian equivalence is a tell-tale: because we do not believe that even in the presence of perfect foresight and perfect certainty that the parent will make an equal and opposite offset of her social security transfer in terms of an increased bequest to her child. Something must be missing from the motivation in Barro’s model; otherwise it would not have given rise to results that are so surprising.

But who says we don't believe that a "parent will make an equal and opposite offset of her social security transfer in terms of an increased bequest to her child"?  Imagine this scenario:  You are taking your daughter out to dinner, and it is your intent and desire to pick up the tab.  But when you excuse yourself to go to the bathroom, the waiter brings the bill, gives it to your daughter, who dutifully hands over her credit card for payment.  Because this frustrates your intentions, you will likely respond by simply reimbursing her. 

Barro's formulation of the Ricardian equivalence  hypothesis invites you to think about government-created transfers from parents to children in exactly this way, and in this light my "everyday experience and observation" makes the Ricardian equivalence idea seem pretty darn plausible.  Of course, I might quickly start coming up with all the reasons that social security transfers are not like a face-to-face dinner, and those reasons would look very much like the list above.  But I wouldn't reject Ricardian equivalence because it is "bad motivation" to assume that my well-being depends on the well-being of my children. I would reject it because the assumption of perfect certainty, perfect markets, and so on, seem inappropriate to the circumstances of the question, and lead to bad predictions -- that is, predictions that do not conform to what we observe in the real world.

That, in simple terms is what Friedman's 'parsimonious modeling' is all about -- not truth arrived at through some process of introspection, but a useful set of assumptions that help us explain the "facts" we endeavor to understand.  In the balance of his discussion on Ricardian equivalence, Professor Akerlof speaks approvingly of thinking about people as being driven by the "warm glow" of giving:

[James] Andreoni thus describes the utility missing from the standard utility function as that arising from the “warm glow” from giving... We know that the “warm glow” does not come from the utility the parent derives from her own consumption; nor, yet more utility of her child (as the child’s utility depends on its own tellingly, it does not derive from the consumption). It enters the utility function as a separate term.

I can imagine an argument that proceeds as follows: 1) The predictions of the benchmark Ricardian equivalence hypothesis do not appear to be consistent with the existing evidence on things like social security transfers -- such transfers are not neutral in their effects on consumption; 2) The failure of the benchmark hypothesis could be wrong because the assumptions about parents' preferences are "wrong", or because any number of other maintained assumptions (such as the assumption of perfect certainty) are "wrong"; 3) However, other evidence--such as the observation that people seem to prefer giving presents to giving money, even though the latter would seem to provide the best chance of maximizing the happiness of the recipient -- argues in favor of a "warm glow" view of preferences rather than one in which parents fully internalize the wishes of their children.

Now that's an argument I understand, but it is one that seems like completely standard operating procedure for most economists.  I'm just not sure what the "missing motivation" adds to the mix.

January 9, 2007 in This, That, and the Other | Permalink

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Listed below are links to blogs that reference Sensible Economics? :

» Identity and economics: what are we missing? from New Economist
Is identity the missing motivation of economics? UC Berkeley's George Akerlof and University of Maryland's Rachel Kranton certainly think so. In a recent London lecture at the LSE, Akerlof explains how this interest arose: In the spring of 1996 Rachel ... [Read More]

Tracked on May 28, 2007 5:23:42 PM

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